Tuesday, January 26, 2016

Analyzing a Property's Cash Flow Statement & How to Create a Real Estate Pro Forma (part 7 of pro forma building series)


Here's a list of everything we've covered so far:

Part 1 - Overview on how to calculate down to the NOI line item.
Part 2 - Intro to lease structures and calculating the gross potential revenue line item.
Part 3 - A look at reimbursement methods and how to calculate reimbursement income.
Part 4 - How to calculate the other income line item and an intro to income adjustments.
Part 5 - Rent abatements overview and calculation example.
Part 6 - Absorption and turnover vacancy explanation and intro to tenant improvements.
Part 7 - General vacancy allowance explanation and calculation example.
Part 8 - Operating expenses explanation.
Part 9 - Constructing a sources and uses table.
Part 10 - Building a debt schedule.
Part 11 - Calculating levered IRR.
Part 12 - DCF analysis.
Part 13 - Loan sizing.

Here's our simple example pro forma spreadsheet to follow along with as well.

In part 7 we'll look at the "General Vacancy Allowance" line item.under the "Income Adjustments" category.

What is General Vacancy?

A general vacancy allowance is an extra buffer built into pro formas for conservatism. The best way to think of it is a given submarket has a certain amount of vacancy and your property will tend to average that vacancy rate over time. When underwriting the property, you should assume your property will, at best, match that market vacancy in spite of your excellent operational skills.

For example, a given submarket might have a vacancy rate of 10%. Let's say a property within that submarket has 5 tenants each with an equal amount of square footage. The first year you buy the property it's fully occupied. The next year let's assume one of the tenants vacates their suite for the entire year so your vacancy rate for that year is 20%. Your average vacancy rate over those 2 years is 10%, the market vacancy rate. A general vacancy rate assumes your property's vacancy will track that market vacancy rate over time.

How to Calculate General Vacancy Allowance

There are some nuances to the general vacancy allowance that should be noted. First, it's only factored in when the vacancy is less than the allowance. For example, if a property is only 80% occupied, meaning a vacancy rate of 20%, and the general vacancy allowance rate is 10%, you wouldn't factor in a general vacancy allowance. However, if the vacancy rate is 5% and the general vacancy allowance is 10%, then the total income needs to be adjusted 5% lower.

Another nuance is that the vacancy allowance is typically calculated as a % of total income, not just rental income, or rental and reimbursement income. Other income is adjusted lower as well. The rationale is that most other income items, such as parking, will decrease as a result of decreased activity at the property.

In our pro forma, we don't take a general vacancy allowance in year 1 or year 2. In year 1, because Tenant 1 doesn't pay rent for 3 months (rent abatements), the vacancy for that year is calculated as .25 (number of months without paying rent / 12) * .5 (tenant square footage / total property square footage) = 12.5%.

In year 2, we assume Tenant 2 vacates the property and it takes a full year to release the space. That's a full year of having half the property vacant, resulting in a vacancy rate of 50%.

Quick tip: If your calculations are correct, you should be able to calculate your property vacancy rate by simply dividing the absorption and turnover vacancy line item divided by the total income. You also have to add in rent abatements / gross potential revenue. Those two numbers added together give you the property vacancy rate for that year.

In year 3 and 4 in our pro forma, occupancy is 100%, so we need to calculate a general vacancy allowance. It's simply calculated by taking our general vacancy allowance assumption, 5%, and multiplying it by the total potential income.

Part 8 coming soon!

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